Wednesday, March 25, 2020

How Low Can Oil Go?

How bad is too bad for oil markets? As prices plummet toward the lowest levels since the commodity’s inception, could a $5 a barrel oil prices really become a reality? U.S. oil futures just hit an 18-year low as an oil-price war between Saudi Arabia and Russia rolls on, and that has a few traders and analysts wondering how low can prices go?

History tells us that the cure for low prices is low prices. Typically, cheap fuel means increased purchases, and higher demand would cause prices to rise again. But the spread of the Covid-19 virus makes that demand response impossible today. As more and more countries lockdown, oil demand is plummeting as quickly as the prices. Last week, West Texas Intermediate fell below $20 a barrel, its lowest level since 2002, while Brent hovered just above that landmark threshold.

The other pressure relief for low oil prices usually comes from the suppliers. To stop oil prices from falling further, big producers need to reduce drilling and bring supply down to level with demand. However, the global leading producers are doing exactly the opposite.

The three-year pact between OPEC and Russia ended in acrimony at the start of the month, after Moscow refused to support deeper oil cuts to cope with the COVID-19 outbreak. OPEC responded by removing all limits on its own production. Saudi Arabia has ramped up production, targeting big refiners of Russian oil in Europe and Asia. Saudi Arabia plans to increase its production to 12.3 million barrels a day from 9.7 million in February.

What initially seemed like a move by the Saudis to pull Moscow back to the negotiating table, now appears to be a tactic aimed to reinstate the Kingdom’s long-term market-share dominance, in part by pushing higher-cost U.S. producers into bankruptcy.

The imbalance between supply and demand could approach 10 million barrels per day, as Saudi Arabia begins to “open the taps”. This will lead to hundreds of millions of barrels of oil being put into storage throughout the world. Oil tankers are already commissioned to hold crude and refined products for sale at a later date, in the hope and expectation that prices will rise again. Last time energy investors experienced such an overwhelming plunge in prices was in 2014. Crude oil had dropped to $26 from $110, over just a two-year period. But prices didn’t stay that low for long, and it quickly jumped back into the $40s.This time, however, that kind of snapback doesn’t look likely.

The only way for prices to rise now is at the expense of U.S. producing companies. Although that is beginning to happen, it is probably not happening quickly enough to force an increase in the barrel price.

Goldman Sachs announced last week that the bank was lowering its Brent forecast to $20 a barrel for the second quarter, down from their original forecast of $30. Goldman said that the virus will likely lead to far worse outcomes than previously thought — even below estimates from just a month ago — for both the commodities and equity market.

Citigroup has shared predictions for the second quarter where Brent would average around $17 a barrel or lower, with a pessimistic case of a $5 average and the potential for negative physical prices in some regions, due to the absence of logistics and storage. Energy Aspects said Brent is at risk of seeing $10 a barrel in April but expects prices are likely to remain around $20 throughout 2020.

Picking a bottom in the crude market is always a stress-inducing task, especially when prices are seeing new lows daily. However, history has told us that these dramatic downturns are often temporary rather than permanent contractions. Oil has a tendency to bounce back on basic supply and demand economics.